If you’re Daddy Warbucks’s grandson and want to pass the wealth on to your heirs, the easy-to-forget gift tax can take an enormous bite out of your monetary and property gifts. That’s why many of the nation’s well-heeled take advantage of a potentially giant tax loophole known as a Grantor Retained Annuity Trust (GRAT).
This legal way to save big money when gifting assets consists of an irrevocable trust. The grantor (creator) of the trust transfers assets and initially pays a tax, and then he or she receives, annually or more frequently, a regular payment (annuity) for a certain number of years. At the end of the payment term, any remaining assets in the trust pass on tax free to designated beneficiaries, who are usually close family members.
Who uses GRATs?
Any gifts you give above the lifetime gift exclusion of $5.25 million are taxed at 40 percent. Even for the super-rich, that tax hurts. So at that limit, a GRAT makes sense. Considered an effective estate “freeze” technique, because it suspends and potentially eliminates gift tax payments, a GRAT is used by those who have appreciating estates and the tax exposure that comes with them.
This tax savings vehicle is so attractive that younger wealthy individuals who you might not associate with estate planning have opened GRATs, including the co-founders of Facebook, Mark Zuckerberg and Dustin Moskovitz, who began opening them when they were just 24.
How GRATs Work, and the 7520 Rate (Complicated Version)
“The basic format of a GRAT can be described as follows: An individual, referred to as the “grantor,” transfers assets to a trust and retains an annuity from the trust for a term of years. To avoid a gift upon formation of the GRAT, the retained annuity is designed to equal the value of the assets transferred based upon the term of the trust and an assumed growth rate over the term set forth by the Treasury Department.
“This rate is fixed at the time of formation of the GRAT and is referred to as the “7520 rate.” The 7520 rate is named after the applicable provisions of the Internal Revenue Code and fluctuates monthly based on current market yields on government obligations. This rate essentially provides a “hurdle” which is necessary for the trust assets to overcome in order for the GRAT to be effective.” (Forbes)
The 7520 rate, which is set by the U.S. Treasury, determines the amount of interest that will be paid out of the fund to the government during the life of the GRAT. This interest rate is currently at 2.2 percent, but fluctuates according to the state of certain interest rates. It has been as low as 1 percent in January 2013 and as high as almost 12 percent back in 1989.
For GRATs to work as intended by those who have them, a lower interest rate is ideal. A low interest rate equals more money in the fund for its beneficiaries. If the 7520 interest rate is high, the interest could potentially eat up the fund, leaving little to no money for the beneficiary.
How GRATs Work (Not as Complicated)
This topic is so complicated, it’s no wonder the wealthy have attorneys on staff. But we’ll try to simplify it for you:
- You (uber-wealthy with an amassed fortune) want your wealth to live on, through your kids, without being taxed to bits.
- You have more than $5.25 million to pass on (less than that in a lifetime is untaxed, more than that is taxed like income–40%) OR
- You want to pass on more than your $14,000 annual limit ($28,000 if you’re married)
- You transfer your money into a GRAT, a type of irrevocable trust, to hopefully* avoid the estate and gift tax.
- With the GRAT, you receive an annuity payment from the trust (cash money!) for the term of the GRAT (say, 10 years), at the 7520 rate.
- Once those 10 years are up, if you’re still alive and there’s money left in the trust, your beneficiaries get a tax-free windfall.
*If you don’t outlive the trust, then the amount transferred into the GRAT will revert back to the estate, and be subject to the estate tax. Also, if the GRAT grows at a lower rate than the 7520 rate, then you’ll get the trust back at its depreciated value and be out the legal fees it took to set up the trust.
“For example, Monica is 55. She transferred $1 million in assets to a GRAT that paid her an annuity of $100,000 per year for the shorter of her life or 10 years. At the end of the 10-year term, the residual assets go to Monica’s son, Billy. The Sec. 7520 rate in effect when Monica established the GRAT was 4.6%, but the trust’s assets earn an actual return of 8%.
“According to IRS tables, the value of Monica’s gift to Billy was approximately $248,400. But Billy’s actual residual interest, based on the 8% rate of return, is $710,269. Monica received annuity payments totaling $1 million over 10 years, while removing more than $700,000 from her estate. Assuming Monica has at least $250,000 of her $1 million lifetime gift tax exemption still available, the entire transaction is gift-tax free.” (WegnerCPAs)
Structuring GRATs to minimize failure
A few things can go wrong with a GRAT. If the grantor dies before the term ends, all of the money left will go back into the grantor’s estate and no tax savings will occur. If a grantor is older, he may set up a series of short-term GRATs rather than a long-term one. Currently, a GRAT can be set up for as little as two years, or as long as a grantor wants. When multiple GRATs are set up, if any “fail” in terms of little or no money left in the fund at termination, those losses can be offset by the gains of other successful GRATs.
Too good to be true?
GRATs may sound too good to be true, but they aren’t—yet. The attractiveness of the loophole and the fact that the IRS has lost billions in interest as a result has prompted those in the Obama Administration to target GRATs.
Changes proposed to this estate building benefit include a minimum term of 10 years, which makes the likelihood of the grantor dying prior to the termination of the fund more likely, and the elimination of Zeroed-out GRATs. Rather than filling the fund with the hope of having just enough to pay the annuity and zero out, which some investors do in order to avoid paying gift tax, grantors would be required to invest a substantial amount of money.
If either of these limitations is imposed, GRATs will be much less enticing. In the meantime, though, if you have a few million dollars, this is an excellent potentially tax-free way to spread your wealth around.
Julie Bawden-Davis is a widely published journalist specializing in personal finance and small business. She has written 10 books and more than 2,500 articles for a wide variety of national and international publications, including Parade.com, where she has a weekly column. In addition to contributing to SuperMoney, her work has appeared in publications such as American Express OPEN Forum, The Hartford and Forbes.